Putting $12 billion to work would be difficult even in good times. In a down market with low valuations and scarce exit opportunities, the task is downright ominous. Add to that a slew of new consultants, gatekeepers, fund managers and staff to manage the portfolio, and you’ve got the California State Teachers’ Retirement System (CalSTRS).
In October, the public pension fund voted to increase its alternative asset allocation to 8%, up from the current value of 4.9%, or to about $4.6 billion. Under a new asset allocation target adopted at the plan’s October board meeting, that target could translate into $12 billion worth of private equity commitments within four years.
Other state pension funds are also finding that now is a good time to be in private equity. The North Carolina House of Representatives signed off on the state’s $59 billion employees’ retirement system’s plan to invest up to 5% of its assets in alternative investments, up from less than 1%. Also, the Indiana Public Employees’ Retirement Fund raised its alternative allocation to 5%.
The asset allocation review, a joint effort between the plan’s investment committee and its plan consultant Pension Consulting Alliance Inc., is the first CalSTRS has undertaken in at least three years. The board, which voted unanimously to accept the changes, adopted both an implementation plan and a new target range to reflect its changed priorities at a closed-door meeting last month.
“This is the final step in a process to adopt a new investment policy for the current year that has asset allocation targets and a plan for implementation,” said Chief Investment Officer Christopher Ailman. “It will be prudent to build over a four-year period, and we’re going to go after this as investors. We’re not going to chase targets to chase targets. We’ll invest as fast or as slowly as opportunities present themselves.”
The new asset allocation target calls for a 5% allocation to private equity at the end of fiscal year 2002, climbing one percentage point each year to hit a long-term goal of 8% by 2005. Under the new asset allocation, the fund’s overall equity/debt split remains unchanged at 73% equity and 27% fixed income or stable assets.
Slow and gradual as the changes may be, already there are stumbling blocks in the way. The alternative investment staff, for example, counts nine investment professionals on its roster. It had planned to hire another six to manage the portfolio as it grows, and compensate those managers at a level similar to private investment managers. However, following a hiring freeze recently implemented by California Governor Gray Davis, CalSTRS, like many stage agencies, cannot fill those positions.
“We’re on hold in filling positions in investments that are open right now. We may feel the impact in some of our program areas, especially new programs,” Ailman said.
At the same time, the investment committee has set forward a request for proposal that would split the role of its consultant into separate gatekeeper and strategist functions. The consultant would monitor investments and provide advice on strategy, while the gatekeeper would act as a program adviser. Pathway Capital Management LLC (PCM) currently plays both roles, thus raising potential conflict of interest issues if the consultant were to need to review itself. The proposal may also bundle legal services into the gatekeeper’s role.
An RFP will be issued this month and applications are due in February.
The proposal already has raised budgetary concerns. While the plan pays out $300,000 to $500,000 to PCM annually for its consultant services and $1.5 million annually for its gatekeeping functions, the cost of a new contract – a three-year contract with two one-year extensions – could cost the plan between $1 million and $5 million annually.
“By bifurcating the process, we need to be clear as to what the consultant will do. We need to have that person truly independent of what the staff is doing.
You’re not going to get that at $100,000 a year,” said Allan Emkin, PCM’s representative to CalSTRS. “If you want true expertise, not just a rubber stamp that comes out of your staff and consultants, you have to make sure they have the resources to make that decision so you have good advice.”
Despite such obstacles, the investment staff remains firm in its confidence. It is eager to build out its private equity portfolio and maintain the best practices while doing so.
“As the program grows, our costs will grow,” Ailman said. “As we grow, we want to maintain best practices and the best and brightest expertise in the world.
[Our practices] could be better.”
CalSTRS began investing in private equity in 1992 under the direction of Abbott Capital. Though the portfolio was relatively small, especially compared with the $41 billion portfolio of its cross-town rival, CalPERS, it began to carve out some of its longest and most lucrative investment partnerships in those early years.
CalSTRS, for example, began investing with New Enterprise Associates in 1990 with a stake in NEA V, and has remained a partner in NEA VI, NEA VII, NEAVIII, NEA IX and NEA X. It has created a similar long-tern relationship with Madison Dearborn and Summit Ventures.
Its private equity portfolio is valued at $4.8 billion and includes 109 partnerships and 14 co-investments. Within the portfolio, 55% is dedicated to the buyouts market, while 17.3% is dedicated to venture capital – invested largely in early-stage funds on the West Coast. While its buyouts portion of the plan is fully funded, the VC segment remains short of its 20% target within the alternative investments portfolio.